A slam at the bond rating agencies (updated)

Remember how bond ratings agency Moody's made the questionable assumption that there would be 225 events a year at the Barclays Center? There's no effective oversight regarding rating agencies like Moody's, Standard and Poor's, and Fitch.

In Ratings Agencies Are Overrated, Hugo Dixon (editor of Reuters Breakingviews, the commentary arm of Reuters) and Christopher Swan write in the Times:

Why do markets still pay attention to what rating agencies have to say? After their appalling record predicting the subprime mortgage crisis, it is astonishing and sad that investors still seem to quake when Standard & Poor’s reduces Greece’s rating to junk status and downgrades Spain’s.

A Martian would find it hard to understand why anybody gives any credence at all to S.& P. and its rivals. It’s not just that they were pumping up the subprime market. For example, the agencies gave a AAA rating to Abacus, Goldman Sachs’s synthetic collateralized debt obligation, after smart investors saw trouble in the market.

They point to other miscues and then explain how the ratings agencies remain embedded in the current system. Still, they conclude:

It is high time regulators and investors dethroned them from their privileged status.

And another criticism

In a 5/2/10 editorial headlined What About the Raters?, the Times opined:

Everyone (except Wall Street bankers) seems to be outraged about Wall Street banks, which made billions by trading complex confections of dicey mortgages and then passed us the tab when the investments went belly up. But what about the agencies that bestowed triple-A ratings on many of the noxious financial products?

Moody’s, Standard & Poor’s and Fitch, whose ratings assured investors that the newfangled investments were as safe as United States Treasury bonds, arguably bear as much responsibility for the financial crisis as the banks that put the investments together. But the raters have mostly avoided public scrutiny, and from the look of Democrats’ current proposals to overhaul financial regulation, it looks as if they will remain off the hook.

...It is not just that ratings agencies are incompetent, made wrong assumptions about the housing market and used flawed models to evaluate mortgage-backed securities. Their business is rife with conflicts of interest. The banks pay the raters and have an enormous incentive to shop around for ratings. E-mail made public in April indicates that raters give in to the temptation to manage their ratings in order to acquire more business.

...And yet, the financial reform bills before Congress have only vague proposals to fix the agencies.

...That is not enough. Some good ideas are floating around to do much better. If raters are considered to be a public good, they should be financed like a public good, with a tax or other levy, and paid by the government. Another option would be to let banks pay for ratings but take away their ability to choose who rates their bonds, letting the S.E.C. decide based on raters’ performance.

If there is no way to improve raters’ track record, a more drastic step would be to eliminate them, or at least eliminate the legal requirement that some insurance companies, pension funds and other entities hold assets with high ratings, a rule that gives the raters enormous quasi-regulatory power.